ATTENTION CLIENTS OF FREEDOM ONE INVESTMENT ADVISORS
Author: Donald I. Gregg, Chief Investment Officer
August 27, 2007
What is happening in the stock market and why?
The stock and bond markets have experienced significant
swings over the last five months. The S&P 500, the broad measure of the
U.S. stock market, was at 1347 on March 15, 2007 and went almost straight up
to 1553 on July 19, for a gain of 15%. Much of this upswing
can be attributed to better than expected corporate earnings from U.S. and
foreign based companies and optimism on world- wide economic growth.
Since July 19, the S&P 500 dropped to an intra-day low of
1370 on August 16, a loss of 11.8%. As of August 24, the S&P 500 has
recovered some of the recent losses; the S&P 500 is at 1483, up 5.5% for the
year.
The stock market slide started with a liquidity crisis
prompted by the bankruptcy of firms lending to sub prime mortgage borrowers.
Sub prime is defined as individuals with unfavorable credit ratings, who
often have little or no home equity. These were variable rate loans that
originated in the 2002-2004 period when rates were very low. These rates
provided a new opportunity for individuals who could only afford to rent in
the past and now had a chance to own a home. For investors, this market
represented a new investment opportunity. Lending to these individuals
looked to be very profitable, as margins seemed high and default risks were
seen as reasonable. But, variable interest rates are adjusted periodically
and have increased by at least 4%, causing monthly mortgage payments to
increase by as much as 40%. Borrowers have not been able to afford these
increased payments, causing delinquencies and defaults to increase
significantly. This, in turn, caused distress in the financial markets,
with a number of headline-making events, as follows:
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In April, New Century Financial, sub prime mortgage
lender, filed for bankruptcy protection.
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In May, UBS AG, a large Swiss financial company, said its
hedge fund business had lost approximately $125 million in the first
quarter, largely due to the investments it made in the U.S. sub prime
mortgage field.
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In July, Bear Stearns closed a pair of hedge funds after
it lost more than US $20 billion on mortgage-backed investments.
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On August 6, American Home Mortgage Investment Corp.,
once the nation's 10th largest mortgage lender, filed for bankruptcy.
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On August 9, France's biggest bank, BNP Paribas, froze US
$2.2 billion held in three funds because their exposure to sub prime
mortgages in the U.S. solidified fears that risk was spreading
worldwide.
Meanwhile, falling U.S. home prices and a spike in
payment defaults scared investors away from mortgage debt, including bonds
and other securities backed by home loans. Banks and governments worldwide
reevaluated these holdings in their portfolios and hedge funds were closing
down in a bid to stave off investors who wanted to redeem their investments.
With cash reserves running low, banks were refusing to lend to each other
and the interest rates that banks charged each other rose well above the 4%
level set by the ECB (European Central Bank). This prompted the ECB’s
unprecedented lending of $265 billion. The U.S. Federal Reserve infused
cash of $64 billion and central banks in Japan and Australia another $7
billion and $3 billion respectively. As a result, the liquidity crisis was
slowed and the bond and stock markets now show signs of recovery.
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What about the future?
We are optimistic about the
long term prospects for the global stock and bond markets. Global economies
are growing and the markets appear to be reasonably priced. To date, we are
pleased with the prompt responses of the central banks and how the markets
have responded. Of course, we do not know what the final outcome will be for
the liquidity crisis that has been brought on by the sub prime lending
crisis. We will continue to closely monitor the situation.
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